Mergers and Acquisitions For Dummies (62 page)

Salutation and preamble

The LOI starts with basics, like any other business letter. After a flowery greeting, Buyer usually provides a lengthy preamble with some comments about how excited he is to submit the LOI and how beautifully Seller and Buyer will fit together after a deal is done. This section is simply cosmetic politeness: nice, but not important.

Valuation and deal structure

Valuation (which I cover in Chapter 12) is the key number everyone looks for. Usually the valuation appears in the third or fourth paragraph of the LOI. Buyers often load up their LOIs with a bunch of boilerplate in hopes of differentiating themselves from other Buyers, but this boilerplate isn't what's important; the valuation is. The valuation in the LOI should be a static number (as opposed to the range typically seen in the IOI).

The structure of the deal is also very important, and frankly, many first-time Sellers overlook it. The valuation may provide an eye-popping number, but the devil is in the details. Here are some deal-structure questions to consider:

How much of that valuation does Buyer pay in cash at closing?
Cash at closing (I'm repeating myself here for dramatic effect) is the most important detail for any Seller because Seller can't spend a note, an earn-out, or stock. Cash is king, and a wise Seller places a premium on getting actual cash as opposed to a promise to maybe get some cash at some point in the future.

How much of the valuation is in the form of a contingent payment?
Contingent payments
include earn-outs, notes, and even stock in Buyer's company (see Chapter 12 for more). I consider these forms of payment contingent because Seller may or may not eventually receive that money.

If the LOI includes contingent payments, what are the details?

•
How much money is in the form of a note?
What is the interest rate, and when does Seller receive that money? Does the interest
accrue
(all the interest is paid when the principal is paid)? Is the note
amortized
(Seller receives interest and principal payments)? Or is the note
interest only
(Seller receives regular interest payments and a balloon payment at the end), and if so, how often are the interest payments due?

•
What are the specifics of any proposed earn-out?
Seller should be most concerned with one thing: how she gets her money! You can structure earn-outs in virtually limitless ways, but in my strongly held opinion, the earn-out should be simple and easy to understand. The more complex the deal, the less likely Seller ever sees any money from the earn-out. Check out Chapter 21 for some earn-out ideas.

•
How easily can Seller convert any stock to cash?
If the stock is
thinly traded
(doesn't trade many shares daily) and is on a lesser exchange (OTC or Pink Sheets), Seller has a lower probability of converting that stock to cash than if the stock were a high-volume stock on NYSE or NASDAQ.

No single contingent payment structure is right or wrong for any given deal. Each deal is different. Seller needs to confer with her advisors and weigh the merits of a particular offer.

Buyers, if a Seller rejects your offer after reviewing it, provide that reluctant Seller with a detailed calculation of the deal. Many Sellers simply look at the cash at closing and they may miss the true value of the deal. Calculate the proceeds over time. Add in earn-outs, notes, stock, and so on.

Holdback and escrow

Most deals delineated in an LOI include a
holdback
, an amount Buyer withholds from Seller for a period of time just in case the company has some sort of problem (usually a breach of a representation or warranty, which is covered in Chapter 15) after the deal closes. The holdback goes into a third-party account called
escrow.
This escrowed money is released to Seller, assuming Buyer doesn't make claims to the money.

Escrow should be 10 percent (or less) of the purchase price, and that money should be paid to Seller within 12 months of close. However, a deal involving a Seller with a history of problems or challenged earnings may warrant a higher holdback amount and a longer period of time.

Some Sellers view the escrow as money they're not receiving, but Sellers should remember that Buyers need to come to the closing meeting with that money. Just because Seller doesn't immediately receive that money doesn't mean Buyer isn't providing it. If the purchase price is $10 million with $1 million to be placed in escrow, Buyer needs to come to the closing with $10 million!

Representations and warranties

Buyer and Seller agree to a slew of representations and warranties (sometimes abbreviated
reps and warranties
or
R&W
).
Representations and warranties
are legal promises regarding past and future events, and you should take them very seriously. I provide more detail about reps and warranties in Chapter 15.

Sellers can and often should provide Buyers with R&Ws for past events such as the previous year's financial statements. But providing R&Ws for future events is a mistake because the future has no guarantees. Asking Seller to provide R&Ws that, say, the company's top customer will still be the top customer in one year is an unreasonable request.

The R&Ws tend to be biased against the Seller, and so Sellers usually provide far more R&Ws than Buyers do because Buyers have many more worries about the deal than Sellers.

The biggest concern for Seller is that Buyer shows up at closing with the money; Seller isn't too preoccupied with getting Buyer's R&Ws. After the deal closes, Seller doesn't have financial responsibility for the company; Buyer does. That's why Buyer is so keen on Seller providing some reps and warranties.

For Buyer to have the ability to claim some of the escrow money against Seller, a problem usually needs be the result of Seller's failure to disclose something to Buyer, or worse, of some sort of fraud or malfeasance by Seller. If the problem is the result of Buyer making a mistake post-close, it's Buyer's problem, and Buyer can't claim a breach of a rep or warranty.

If the business takes a nose dive due to a general economic decline, that's not the fault of Seller, and Buyer will not be able to claim a breach of a rep or warranty.

Financing

Most LOIs contain some info about where Buyer proposes to obtain the dough needed to effect the transaction. I heartily recommend Sellers pay very careful attention to this part of the LOI. The phrase you're on the lookout for is
financing contingency.

A financing contingency is a hedge for Buyer. He's saying he may not have the money right now and hopes to obtain it before closing, but he wants a way out of the deal in the event that he can't get the necessary money.

As a Seller, tread carefully if a Buyer is asking for a financing contingency, especially if the Buyer is a large company or a private equity (PE) firm (see Chapter 6). I'm not saying a financing contingency is inherently bad — deals can still get done if a Buyer wants to include one — but Sellers should try to move forward with an LOI that doesn't include a financing contingency if at all possible. If Buyer decides not to do the deal, all he has to do is claim he can't get the money. The inability to get the money contradicts his claims to be a big PE firm or another sizable company: If Buyer is using his strong financial position to entice Seller, then why would that Buyer need a financing contingency?

Due diligence and timing

Due diligence
(which I explore further in Chapter 14) is the inspection period for Buyer. It comprises a short section, perhaps just a single sentence, in the LOI where Buyer indicates how long he needs to complete it. After Buyer successfully concludes due diligence, he can close the deal.

Sellers should pay close attention to the length of time Buyer seeks; if it's too long, Seller shouldn't proceed until Buyer agrees to conduct due diligence and close the deal in a shorter, more reasonable amount of time. As a guideline, Buyer should be able to conduct due diligence and close within 60 days of signing the LOI.

Approvals and conditions

This section is usually more boilerplate where the Buyer may reference certain executives who need to sign off on the deal before it can close. Buyer may also ask Seller to make sure her ducks are in a row, so to speak, so that whoever needs to approve the transaction on her side is willing to do so.

As with a financing contingency (see the earlier “Financing” section), Sellers shouldn't move forward with an LOI if a Buyer is including what amounts to an approval contingency — that is, a hedge for the Buyer to back out of the deal simply by claiming some executive won't agree to the deal. Make sure closing the deal isn't contingent upon the Buyer gaining approval of some yet-unseen executive.